<PAGE>
- -------------------------------------------------------------------------------
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
--------------------
FORM 10-Q
--------------------
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended March 31, 2000
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the transition period from ___________ to _____________
Commission File Number 0-20191
-------
ODS NETWORKS, INC.
------------------
(Exact name of Registrant as specified in its charter)
DELAWARE 75-1911917
-------- ----------
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
1101 EAST ARAPAHO ROAD, RICHARDSON, TEXAS 75081
-----------------------------------------------
(Address of principal executive offices)
(Zip Code)
(972) 234-6400
----------------------------------------------------
(Registrant's telephone number, including area code)
NOT APPLICABLE
-------------------------------------------
(Former name, if changed since last report)
* * * * * * * * * *
Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports), and (2) has been subject to
such filing requirements for the past 90 days: Yes X No
----- -----
The number of shares outstanding of the Registrant's Common Stock, $.01 par
value, on April 28, 2000 was 19,477,305.
- -------------------------------------------------------------------------------
<PAGE>
ODS NETWORKS, INC.
INDEX
<TABLE>
<CAPTION>
PAGE
----
<S> <C>
PART I - FINANCIAL INFORMATION
Item 1. Financial Statements (Unaudited)
Condensed Consolidated Balance Sheets as of March 31, 2000
and December 31, 1999 . . . . . . . . . . . . . . . . . . . . . 3
Condensed Consolidated Statements of Operations for the three months
ended March 31, 2000 and March 31, 1999 . . . . . . . . . . . . 4
Condensed Consolidated Statements of Cash Flows for the three months
ended March 31, 2000 and March 31, 1999 . . . . . . . . . . . . 5
Notes to Condensed Consolidated Financial Statements . . . . . . . . . 6-11
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations . . . . . . . . . . . . . . . . . 11-20
Item 3. Quantitative and Qualitative Disclosures About Market Risk 21
PART II - OTHER INFORMATION
Item 2. Changes in Securities . . . . . . . . . . . . . . . . . . . 22
Item 6. Exhibits and Reports on Form 8-K . . . . . . . . . . . . . . 22
Signature Page . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
</TABLE>
2
<PAGE>
PART I - FINANCIAL INFORMATION
Item 1. Financial Statements.
ODS NETWORKS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands, except par value amounts)
<TABLE>
<CAPTION>
Mar 31, Dec 31,
2000 1999
------------- -------------
(Unaudited)
<S> <C> <C>
ASSETS
Current Assets:
Cash and cash equivalents $ 43,550 $ 12,602
Securities available for sale - 67,633
Short-term investments 30,798 6,100
Accounts receivable, less of allowance of $1,153 in 2000
and $1,171 in 1999 for doubtful accounts and returns 10,370 5,404
Inventories, net 15,131 10,692
Other assets 1,617 1,392
------------- -------------
Total current assets 101,466 103,823
Property and equipment, net 4,343 4,221
Deferred tax assets 2,660 -
Long-term investments 5,270 2,750
Goodwill and intangible assets, net 7,972 9,023
Other assets 602 685
------------- -------------
TOTAL ASSETS $ 122,313 $ 120,502
============= =============
LIABILITES AND STOCKHOLDERS' EQUITY
Current Liabilities:
Accounts payable and accrued expenses $ 11,353 $ 11,901
Deferred revenue 2,927 2,039
Income taxes payable 16,274 -
Deferred tax liability - current - 23,305
------------- -------------
Total current liabilities 30,554 37,245
Deferred tax liability - noncurrent - 1,669
Capital lease obligation 10 11
Stockholders' Equity:
Preferred stock, $.01 par value, authorized
shares - 5,000, No shares issued and outstanding - -
Common stock, $.01 par value,
Authorized shares - 80,000
Issued shares - 19,513 in 2000 and 18,623 in 1999
Outstanding shares - 19,473 in 2000 and 18,583 in 1999 195 186
Common stock held in Treasury, at cost - 40 shares (362) (362)
Additional paid-in capital 36,924 29,996
Net unrealized gain on securities available for sale - 44,083
Retained earnings 55,383 9,242
Note receivable from stockholder - (1,177)
Foreign currency translation adjustment (391) (391)
------------- -------------
Total stockholders' equity 91,749 81,577
------------- -------------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 122,313 $ 120,502
============= =============
</TABLE>
See accompanying notes.
3
<PAGE>
ODS NETWORKS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share amounts)
(Unaudited)
<TABLE>
<CAPTION>
Three months ended
-----------------------------------------
March 31, 2000 March 31, 1999
---------------- ----------------
<S> <C> <C>
Net Sales
Security products $ 6,996 $ 423
Networking products 5,961 13,642
---------------- ----------------
Total net sales 12,957 $ 14,065
Cost of sales:
Security products 5,032 157
Networking products 3,751 7,733
---------------- ----------------
Total cost of sales 8,783 7,890
---------------- ----------------
Gross profit 4,174 6,175
Operating expenses:
Sales and marketing 6,133 4,693
Research and development 4,081 2,330
General and administrative 1,652 1,259
Amortization of intangibles 414 391
---------------- ----------------
Operating loss (8,106) (2,498)
Interest income, net 408 249
Other income 66,353 -
---------------- ----------------
Income (loss) before income taxes 58,655 (2,249)
Income tax expense 12,514 -
---------------- ----------------
Net income (loss) $ 46,141 $ (2,249)
================ ================
Basic earnings (loss) per share $ 2.46 $ (0.12)
================ ================
Diluted earnings (loss) per share $ 2.27 $ (0.12)
================ ================
Weighted average common shares outstanding 18,736 18,530
================ ================
Weighted average shares outstanding
assuming dilution 20,331 18,530
================ ================
</TABLE>
See accompanying notes.
4
<PAGE>
ODS NETWORKS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited)
<TABLE>
<CAPTION>
Three Months Ended
--------------------------------
March 31, March 31,
2000 1999
------------ ------------
<S> <C> <C>
Operating Activities:
Net income (loss) $ 46,141 $ (2,249)
Adjustments to reconcile net income (loss) to net cash provided by (used in)
operating activities:
Gain on sale of available for sale security (66,355) -
Depreciation and amortization 1,602 872
Deferred income tax benefit (3,115) (45)
Changes in operating assets and liabilities:
Accounts receivable (4,966) (1,155)
Income taxes receivable - 38
Inventories (4,439) 1,710
Other assets (142) (132)
Accounts payable and accrued expenses (549) (582)
Income taxes payable 14,605 -
Deferred revenue 888 (369)
------------ ------------
Net cash used in operating activities (16,330) (1,912)
------------ ------------
Investing Activities:
Proceeds from sale of available for sale security 67,055 -
Purchases of available for sale investments (28,718) (1,998)
Maturities of available for sale investments 1,500 6
Purchases of property and equipment (673) (239)
------------ ------------
Net cash provided by (used in) investing activities 39,164 (2,231)
------------ ------------
Financing Activities:
Exercise of warrants and employee stock options 6,937 85
Payments on stockholder loan 1,177 2
------------ ------------
Net cash provided by financing activities 8,114 87
------------ ------------
Effect of foreign currency translation adjustments
on cash and cash equivalents - 1
------------ ------------
Net increase (decrease) in cash and cash equivalents 30,948 (4,055)
Cash and cash equivalents at beginning of period 12,602 16,791
------------ ------------
Cash and cash equivalents at end of period $ 43,550 $ 12,736
============ ============
</TABLE>
See accompanying notes.
5
<PAGE>
ODS NETWORKS, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
1. Description of Business
ODS Networks, Inc. ("ODS", the "Company" or the "Registrant") operates through
two divisions: the Security division which focuses on security software and
integrated solutions, and the Networking division which focuses on high
performance network solutions. The Security division is comprised of the
Company's wholly-owned subsidiary, Intrusion.com, Inc. ("Intrusion.com"),
which develops and markets products which allow customers to create networks
that are protected from access, theft and damage by unauthorized network users
and protected from misuse by curious or disgruntled employees, contractors and
other authorized users. The Networking division is comprised of the Company's
Essential Communication division ("Essential") and its local area networking
assets, which develops and markets products which enable customers to connect
computers and supercomputers to form clusters, workgroups and local area
networks ("LANs") and to build backbones for enterprise-wide networks.
The Company was organized in Texas in September 1983 and reincorporated in
Delaware in October 1995. The Company changed its name in April 1997 from
Optical Data Systems, Inc. to ODS Networks, Inc.
On April 17, 2000, the Company announced that effective June 1, 2000, the
Company's name will change from ODS Networks, Inc. to Intrusion.com, Inc. and
its NASDAQ ticker symbol will change from ODSI to INTZ. On April 17, 2000, the
Company also announced plans to sell, or otherwise dispose of, its Networking
division which includes its Essential division and its local area networking
assets.
2. Basis of Presentation
The accompanying unaudited condensed consolidated financial statements have
been prepared in accordance with generally accepted accounting principles for
interim financial information and with the instructions to Form 10-Q and
Article 10 of Regulation S-X. Accordingly, they do not include all of the
information and footnotes required by generally accepted accounting principles
for complete financial statements. The December 31, 1999 balance sheet was
derived from audited financial statements, but does not include all the
disclosures required by generally accepted accounting principles. However, the
Company believes that the disclosures are adequate to make the information
presented not misleading. In the opinion of management, all the adjustments
(consisting of normal recurring adjustments) considered necessary for fair
presentation have been included. The results of operations for the three month
period ending March 31, 2000 are not necessarily indicative of the results
which may be achieved for the full fiscal year or for any future period. The
condensed consolidated financial statements included herein should be read in
conjunction with the consolidated financial statements and notes thereto
included in the Company's annual report on Form 10-K for the year ended
December 31, 1999. Certain prior year information has been reclassified to
conform with current year presentation.
6
<PAGE>
3. Securities Available for Sale
The Company held 770,745 shares of the common stock of Alteon WebSystems, Inc.
("Alteon") (Nasdaq:ATON) valued at $67.6 million as of December 31, 1999.
Alteon, previously a privately-held company, announced its initial public
offering of 4 million shares of its common stock at $19 per share on September
24, 1999.
The Company's accounting of this investment was in accordance with Financial
Accounting Standard No. 115 (FAS 115), "Accounting for Certain Investments in
Debt and Equity Securities". Under FAS 115, the Company's investment in
Alteon, which was classified as securities available-for-sale, was presented
at its fair value as of December 31, 1999, which was $87.75 per share or $67.6
million. On March 2, 2000, the Company sold its investment of 770,745 shares
of Alteon common stock for $87.00 per share, net of applicable expenses,
generating cash of approximately $67.1 million. The disposition of this stock
generated a pre-tax gain of approximately $66.4 million which was recognized
as other income.
4. Inventories (In thousands)
<TABLE>
<CAPTION>
March 31, December 31,
2000 1999
---------- -----------
(unaudited)
<S> <C> <C>
Inventories consist of:
Raw materials $ 2,725 $ 2,113
Work in progress 1,535 1,016
Finished goods 6,460 5,729
Demonstration systems 4,411 1,834
----------- ----------
$ 15,131 $ 10,692
=========== ==========
</TABLE>
5. Goodwill and Intangibles (In thousands)
Included in goodwill and intangibles are the following:
<TABLE>
<CAPTION>
March 31, December 31,
2000 1999
---------- ------------
(unaudited)
<S> <C> <C>
Security purchased software $ 4,136 $ 4,136
Security intangible asset 135 135
Essential goodwill 3,971 3,971
Essential intangible asset 3,340 3,340
----------- ------------
11,582 11,582
Accumulated amortization (3,610) (2,559)
----------- ------------
$ 7,972 $ 9,023
=========== ============
</TABLE>
7
<PAGE>
6. Accounts Payable and Accrued Expenses (In thousands)
Included in accounts payable and accrued expenses are the following:
<TABLE>
<CAPTION>
March 31, December 31,
2000 1999
---------- -------------
(unaudited)
<S> <C> <C>
Trade accounts payable $ 7,950 $ 8,229
Accrued sales commissions 275 527
Accrued incentive bonus 81 108
Accrued vacation 864 863
Accrued property taxes 39 222
Accrued warranty expense 475 475
Other (individually less than 5% of
current liabilities) 1,669 1,477
----------- ------------
$ 11,353 $ 11,901
=========== ============
</TABLE>
7. Income Taxes Payable
At December 31, 1999, the Company had federal net operating loss carryforwards
of $15.8 million for income tax purposes that begin to expire in 2018,
including federal net operating loss carryforwards of approximately $4.3
million subject to ownership change limitations under the Internal Revenue
Code, as a result of the acquisition of Essential Communications Corporation
("Essential"), which begin to expire in 2008. The Company also had $29.3
million of state net operating loss carryforwards. In addition, the Company
had tentative minimum tax credit carryforward of approximately $0.4 million
which may be carried forward indefinitely.
The gain realized from the sale of the Alteon stock (see note 3) utilized
$13.2 million of federal net operating loss carryforwards, which included
approximately $1.8 million of the federal net operating loss carryforwards
subject to certain limitations. In addition, the $0.4 million of tentative
minimum tax credit was utilized as a result of the sale.
Accordingly, the Company reduced the valuation allowance related to its net
deferred tax assets as a result of the gain realized from the sale of the
Alteon stock. For the quarter ended March 31, 2000, this decrease of the
valuation allowance in the amount of $9.1 million resulted in a reduction to
income tax expense for the quarter ended March 31, 2000 and a reduction to
goodwill (for approximately $0.6 million which is the portion of the Company's
valuation allowance attributable to net operating losses acquired from
Essential). The Company continues to carry a valuation allowance with respect
to the state net operating loss carryforwards as well as for the remaining
$2.6 million of federal net operating loss carryovers subject to limitation
under I.R.C. Section 382.
8
<PAGE>
8. Note Receivable from Stockholder
Note receivable from stockholder of approximately $1.2 million at December 31,
1999 represents amounts loaned to an officer during the third quarter of 1998
secured by the Company's common stock. These amounts were classified as
contra-equity because in the event the officer failed to remit payment, the
Company would have received shares of the Company's common stock. On February
28, 2000, the officer repaid the Company in full including principal of $1.2
million and interest of approximately $98,000.
9. Earnings per Share (In thousands, except per share amounts)
<TABLE>
<CAPTION>
Three Months Ended
-----------------------------------------
March 31, 2000 March 31, 1999
-------------- --------------
(unaudited)
<S> <C> <C>
Numerator:
Net income (loss) $ 46,141 $ (2,249)
-------------- --------------
Numerator for basic and diluted earnings
per share $ 46,141 $ (2,249)
Denominator:
Denominator for basic earnings per share
- weighted average common shares
outstanding 18,736 18,530
Effect of dilutive securities:
Stock options and warrants 1,595 -
-------------- --------------
Denominator for diluted earnings per share
- adjusted weighted average
common shares outstanding 20,331 18,530
============== ==============
Basic earnings (loss) per share $ 2.46 $ (0.12)
============== ==============
Diluted earnings (loss) per share $ 2.27 $ (0.12)
============== ==============
</TABLE>
10. Increase in Shares Outstanding
On March 23, 2000, SAIC Venture Capital Corporation ("SAIC VCC") exercised its
warrant to purchase 750,000 shares of the Company's common stock for $8.00 per
share generating $6 million. The warrant was issued to SAIC VCC's parent,
Science Applications International Corporation ("SAIC"), on September 25, 1998
in conjunction with the acquisition by the Company of the Computer Misuse
Detection System and certain other intellectual property from SAIC. SAIC VCC
holds an additional warrant to purchase 750,000 shares of the Company's common
stock for $10.50 per share on or before September 25, 2000.
9
<PAGE>
11. Comprehensive Income (In thousands)
The following table represents a statement of changes in stockholders' equity
including comprehensive income disclosures:
<TABLE>
<CAPTION>
Note Other
Common Additional from Compre-
Common Stock - Paid-In Stock- Retained hensive
Stock Treasury Capital holder Earnings Income Total
------ -------- ---------- --------- ---------- -------- -------
<S> <C> <C> <C> <C> <C> <C> <C>
Beginning of year
- Dec. 31, 1999 $186 $(362) $29,996 $(1,177) $9,242 $ 43,692 $81,577
Issuance of stock
under stock option
& purchase plans
and warrants 9 - 6,928 - - - 6,937
Net income - - - - 46,141(1) - 46,141
Stockholder note
Repayments - - - 1,177 - - 1,177
Unrealized (loss)
from securities
available for sale - - - - - (44,083)(1) (44,083)
End of Period -
March 31, 2000 $195 $(362) $36,924 - $55,383 $(391) $91,749
====== ======== ========== ========== ======== =======
</TABLE>
(1) Comprehensive income for the quarter ended March 31, 2000 was $2,058,000.
12. Segment Information
In the fourth quarter of 1999, the Company adopted SFAS No. 131, Disclosures
about Segments of an Enterprise and Related Information. SFAS No. 131
establishes standards for the way that companies report information about
operating segments, geographic areas and major customers in annual financial
statements and requires those companies to report selected information about
operating segments in interim financial statements. The adoption of SFAS No.
131 had no effect on the Company's consolidated financial position,
consolidated results of operations or liquidity.
The Company has two business segments: Security and Networking. The Security
segment focuses on security software and integrated solutions and the
Networking segment focuses on high performance network solutions.
<TABLE>
<CAPTION>
Total Corporate Security Networking
--------- --------- --------- ----------
<S> <C> <C> <C> <C>
THREE MONTHS ENDED
MARCH 31, 2000
Total revenue $ 12,957 $ - $ 6,996 $ 5,961
Operating income (loss) (8,106) (9) (7,763) (334)
THREE MONTHS ENDED
MARCH 31, 1999
Total revenue $ 14,065 $ - $ 423 $ 13,642
Operating income (loss) (2,498) (32) (4,624) 2,158
</TABLE>
10
<PAGE>
<TABLE>
<CAPTION>
March 31, December, 31
2000 1999
--------- ------------
<S> <C> <C>
Security Assets $ 22,973 $ 14,356
Networking Assets 19,722 17,061
Corporate Assets 79,618 89,085
--------- ------------
Total Assets $122,313 $ 120,502
========= ============
</TABLE>
On April 17, 2000, the Company announced plans to sell, or otherwise dispose
of, its Networking division which includes its Essential division and its
local area networking assets. Once the Company has met the criteria of
Accounting Principles Board Opinion No. 30 ("APB 30") "Reporting the Results
of Operations - Reporting the Effects of Disposal of a Segment or a Business,
and Extraordinary, Unusual and Infrequently Occurring Events and
Transactions", the company will begin accounting for the Networking segment as
discontinued operations and reclassify historical information for comparative
purposes.
Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
This report contains forward-looking statements, within the meaning of Section
27A of the Securities Act of 1933 and Section 21E of the Securities Exchange
Act of 1934, that involve risks and uncertainties, such as statements
concerning: growth and future operating results; developments in the company's
markets and strategic focus; new products and product enhancements; potential
acquisitions and the integration of acquired businesses, products and
technologies; strategic relationships; and future economic, business and
regulatory conditions. Such forward-looking statements are generally
accompanied by words such as "plan," "estimate," "expect," "believe,"
"should," "would," "could," "anticipate," "may" or other words that convey
uncertainty of future events or outcomes. These forward-looking statements and
other statements made elsewhere in this report are made in reliance on the
Private Securities Litigation Reform Act of 1995. The section below entitled
"Factors That May Affect Future Results of operations" sets forth and
incorporates by reference certain factors that could cause actual future
results of the company to differ materially from these statements.
Overview
The Company develops and markets network security software and integrated
network security solutions and local area networking products. On April 17,
2000, the Company announced that effective June 1, 2000, the Company's name
will change from ODS Networks, Inc. to Intrusion.com, Inc. and its NASDAQ
ticker symbol will change from ODSI to INTZ. On April 17, 2000, the Company
also announced plans to focus on network security software and integrated
network security solutions and also announced plans to sell, or otherwise
dispose of, its local area networking assets. Given the Company's shift in
strategy, the Company's results of operations prior to 2000 do not necessarily
reflect the Company's current business.
11
<PAGE>
Results of Operations
The following table sets forth, for the periods indicated, certain financial
data as a percentage of net sales. The period to period comparison of
financial results is not necessarily indicative of future results.
<TABLE>
<CAPTION>
THREE MONTHS ENDED
---------------------------------------------
MARCH 31, 2000 MARCH 31, 1999
-------------- ---------------
<S> <C> <C>
Net Sales
Security products 54.0 % 3.0 %
Networking products 46.0 97.0
-------------- ---------------
Total net sales 100.0 100.0 %
Cost of sales:
Security products 38.8 1.1
Networking products 29.0 55.0
-------------- ---------------
Cost of sales 67.8 56.1
-------------- ---------------
Gross profit 32.2 43.9
Operating expenses:
Sales and marketing 47.3 33.4
Research and development 31.5 16.6
General and administrative 12.8 8.9
Amortization of intangibles 3.2 2.8
-------------- ---------------
Operating loss (62.6) (17.8)
Interest income, net 3.1 1.8
Other income 512.1 -
-------------- ---------------
Income (loss) before income taxes 452.6 (16.0)
Income tax expense 96.6 -
-------------- ---------------
Net income (loss) 356.0 % (16.0)%
============== ===============
THREE MONTHS ENDED
---------------------------------------------
MARCH 31, 2000 MARCH 31, 1999
-------------- ---------------
Domestic sales 87.4 % 83.8 %
Export sales to:
Europe 7.4 12.3
Canada 1.4 1.9
Asia 3.3 1.0
Latin America 0.5 1.0
-------------- ---------------
Net sales 100.0 % 100.0 %
</TABLE>
12
<PAGE>
Net Sales. Net sales for the quarter ended March 31, 2000 decreased to $13.0
million compared to $14.1 million for the same period of 1999 as sales of the
Company's Networking division declined faster than sales of the Company's
Security division increased. Demand for the Company's Networking products is
expected to continue to decline as the Company continues to shift its focus
and sell, or otherwise dispose of, its Networking division.
Export Sales. Export sales for the quarter ended March 31, 2000 decreased to
$1.6 million compared to $2.3 million for the same period of 1999.
International customers historically have been slower to adopt network
security products than domestic customers.
Concentration of Sales. Sales to TRW Systems & Information Technology ("TRW")
were 33.4% of net sales during the quarter ended March 31, 2000, compared to
no sales for the same period of 1999. Sales to SGI, Inc. ("SGI") were 2.7% of
net sales during the quarter ended March 31, 2000, compared to 18.6% of net
sales for the same period of 1999. Direct net sales to various agencies of the
U.S. Government were 5.7% of net sales during the quarter ended March 31,
2000, compared to 17.3% of net sales for the same period of 1999. In addition,
a portion of the Company's sales to TRW, SGI and other corporations were
resold by those organizations to various agencies of the U.S. Government.
Gross Profit. Gross profit decreased to $4.2 million or 32.2% of net sales for
the quarter ended March 31, 2000 compared to $6.2 million or 43.9% of net
sales for the quarter ended March 31, 1999. Gross profit margins were
negatively impacted during the quarter ended March 31, 2000 due primarily to
pricing pressure and reduced volume discounts related to the local area
networking products, as well as certain costs related to the Company's new
integrated network security solutions. Gross profit margins in future periods
may be affected by several factors such as continued product transition,
declining market demand for prior generation products, obsolescence or surplus
of inventory, shifts in product mix, changes in channels of distribution,
sales volume, fluctuation in manufacturing costs, pricing strategies of the
Company and its competitors and fluctuations in sales of integrated
third-party products. Gross profit margins are typically lower on sales of
integrated third-party products.
Sales and Marketing. Sales and marketing expenses increased to $6.1 million or
47.3% of net sales for the quarter ended March 31, 2000 compared to $4.7
million or 33.4% of net sales for the quarter ended March 31, 1999. Sales and
marketing expenses increased in the three month period ending March 31, 2000
compared to the same period of 1999 due to the Company's launch of
Intrusion.com, Inc., the Company's new network security company, and the
Company's concerted effort in marketing Intrusion.com's products and brand.
Sales and marketing expenses may vary as a percentage of net sales in the
future.
Research and Development. Research and development expenses increased to $4.1
million or 31.5% of net sales for the quarter ended March 31, 2000 compared to
$2.3 million or 16.6% of net sales for the quarter ended March 31, 1999. The
Company's research and development costs are expensed in the period incurred.
Research and development expenses increased in the first three months of 2000
compared to the same period of 1999 as the Company continues to increase its
research and development efforts in its Security division. It is expected that
research and development expenses will continue to increase each quarter
throughout 2000, but may vary as a percentage of net sales in the future.
13
<PAGE>
General and Administrative. General and administrative expenses increased to
$1.7 million or 12.8% of net sales for the quarter ended March 31, 2000
compared to $1.3 million or 8.9% of net sales for the quarter ended March 31,
1999. Much of this increase is attributed to the formation and launch of
Intrusion.com, Inc. General and administrative expense may vary as a
percentage of net sales in the future.
Amortization. Amortization expenses remained relatively unchanged at $0.4
million or 3.2% of net sales for the quarter ended March 31, 2000 compared to
$0.4 million or 2.8% of net sales for the quarter ended March 31, 1999. This
amortization expense is primarily associated with the amortization of
intangible assets related to the acquisition of Essential in the quarter
ending June 30, 1998 and the acquisition of certain assets and intellectual
property from SAIC in the quarter ending September 30, 1998.
Interest. Net interest income increased to $0.4 million for the quarter ended
March 31, 2000 compared to $0.2 million for the same period in 1999. Net
interest income is expected to increase in the quarter ended June 30, 2000 due
to the Company's additional cash balances resulting from the sale of its
Alteon investment (see note 3). Net interest income may vary in the future
based on the Company's cash flow and rate of return on investments.
Income Taxes. The Company's effective tax rate for the quarter ended March 31,
2000 was 21.3%, compared to zero for the quarter ended March 31, 1999. The
effective tax rate for the quarter ended March 31, 2000 varied from the U.S.
statutory rate primarily due to the reduction of the Company's valuation
allowance in the amount of $9.1 million. Without such decrease to the
valuation allowance, the Company's effective tax rate for the quarter ended
March 31, 2000 would have been 36.8%.
Earnings per Share. The Company's earnings per share is calculated in
accordance with Financial Accounting Standards No. 128, "Earnings Per Share".
This method requires calculation of both basic earnings per share and earnings
per share, assuming dilution. Basic earnings per share excludes the dilutive
effect of common stock equivalents such as stock options and warrants, while
earnings per share, assuming dilution includes such dilutive effects. Future
weighted-average shares outstanding calculations will be impacted by the
following factors: (i) the ongoing issuance of common stock associated with
stock options exercises; (ii) the issuance of common stock associated with the
Company's employee stock purchase program or outstanding warrants; (iii) any
fluctuations in the Company's stock price, which could cause changes in the
number of common stock equivalents included in the earnings per share assuming
dilution computation; (iv) the issuance of common stock to effect business
combinations should the Company enter into such transactions; and (v) the
repurchase of common stock by the Company should the Company acquire shares of
its common stock under its stock repurchase program authorized in October,
1999.
14
<PAGE>
Liquidity and Capital Resources
The Company's principal sources of liquidity at March 31, 2000 were $43.5
million of cash and cash equivalents, $30.8 million of short-term investments
and $5.3 million of investments with a stated maturity beyond one year. As of
March 31, 2000, working capital was $70.9 million compared to $66.6 million as
of December 31, 1999.
Cash flows used in operations for the three months ended March 31, 2000 were
$16.3 million, primarily due to an operating loss of $8.1 million and an
increase in inventory and accounts receivable. Inventories increased primarily
due to the Company supporting its existing Networking division and its growing
Security division. Future fluctuations in accounts receivable and inventory
balances will be dependent upon several factors, including, but not limited
to, quarterly sales, ability to collect accounts receivable timely, the
Company's strategy as to building inventory in advance of receiving orders
from customers, and the accuracy of the Company's forecasts of product demand
and component requirements.
Cash provided by investing activities in the quarter ended March 31, 2000 was
$39.2 million, which consisted of net proceeds from the sale of the Alteon
investment (see note 3) of $67.1 million offset by net purchases of available
for sale securities of $27.2 million and equipment purchases of $0.7 million.
Cash provided by financing activities in the quarter ended March 31, 2000 was
$8.1 million, which consisted of $6.9 million for the issuance of common stock
upon the exercise of employee stock options and warrants (see note 10) and
$1.2 million for the repayment of a loan made to a stockholder (see note 8).
On March 2, 2000, the Company sold its investment of 770,745 shares of Alteon
common stock for $87.00 per share, generating cash of approximately $67.1
million. The disposition of this stock generated a pre-tax gain of
approximately $66.4 million (see note 3).
On October 14, 1999, the Company announced a Stock Repurchase Program under
which up to 1.0 million shares of the Company's outstanding common stock may
be acquired in the open market over the next 12 months at the discretion of
management. To-date, the Company has repurchased 40,000 shares at an average
price of $9.05 per share.
At March 31, 2000, the Company did not have any material commitments for
capital expenditures.
During the three months ended March 31, 2000, the Company funded its
operations through the use of cash and cash equivalents.
The Company believes that its cash, cash equivalents, investment balances and
potential cash flow from operations will provide sufficient cash resources to
finance its operations and currently projected capital expenditures through
2000. However, there can be no assurance that the Company's cash resources
will be sufficient for the year 2000.
15
<PAGE>
The Company intends to explore possible acquisitions of businesses, products
and technologies that are complementary to those of the Company. The Company
is continuing to identify and prioritize additional network security
technologies which it may wish to develop, either internally or through the
licensing or acquisition of products from third parties. While the Company
engages from time to time in discussions with respect to potential
acquisitions, there can be no assurances that any acquisitions will be made or
that the Company will be able to successfully integrate any acquired business.
Any material acquisition could result in a decrease to working capital
depending on the amount, timing and nature of the consideration to be paid. In
order to finance acquisitions, it may be necessary for the Company to raise
additional funds through public or private financings. There can be no
assurance that such financings will be available at acceptable terms, if at
all. Equity financings, if any, may result in dilution to the Company's
stockholders.
Factors That May Affect Future Results of Operations
Numerous factors may affect the Company's business and future results of
operations. These factors include, but are not limited to, technological
changes, competition and market acceptance, acquisitions, product transitions,
manufacturing and suppliers, intellectual property and licenses, third-party
products, dependence on key customers, international operations and
intellectual property issues. The discussion below addresses some of these and
other factors. For a more thorough discussion of these and other factors that
may affect the Company's business and future results, see the discussion under
the caption "Factors That May Affect Future Results of Operations" in the
Company's Annual Report on Form 10-K for the year ended December 31, 1999.
Technological Changes. The market for the Company's products is characterized
by frequent product introductions, rapidly changing technology and continued
evolution of new industry standards. The market for security products requires
the Company's products to be compatible and interoperable with products and
architectures offered by various vendors, including networking products,
workstation and personal computer architectures and computer and network
operating systems. The Company's success will depend to a substantial degree
upon its ability to develop and introduce in a timely manner new products and
enhancements to its existing products that meet changing customer requirements
and evolving industry standards. The development of technologically advanced
products is a complex and uncertain process requiring high levels of
innovation as well as the accurate anticipation of technological and market
trends. There can be no assurance that the Company will be able to identify,
develop, manufacture, market and support new or enhanced products successfully
in a timely manner. Further, the Company or its competitors may introduce new
products or product enhancements that shorten the life cycle of or make
obsolete the Company's existing product lines, any of which could have a
material adverse effect on the Company's business, operating results and
financial condition.
Market Acceptance. The Company is pursuing a strategy to increase the
percentage of its revenue generated through indirect sales channels including
distributors, value added resellers, system integrators, original equipment
manufacturers and security service providers. There can be no assurance that
the Company's products will gain market acceptance in these indirect sales
channels. Further, competition among security companies to sell products
through these indirect sales channels could result in significant price
competition and reduced profit margins.
16
<PAGE>
The Company is also pursuing a strategy to broaden and further differentiate
its product line by introducing complementary security products and
incorporating new technologies into its existing product line. There can be no
assurance that the Company will successfully introduce these products or that
such products will gain market acceptance. The Company anticipates competition
from networking companies, network security companies and others in each of
its product lines. The Company anticipates that profit margins will vary among
its product lines and that product mix fluctuations could have an adverse
effect on the Company's overall profit margins.
Plans for Dispositions. On April 17, 2000, the Company announced plans to
sell, or otherwise dispose of, its Networking division which includes its
Essential division and its local area networking assets. The net assets of
this division were $19.7 million as of March 31, 2000. There can be no
assurance that the Company will be able to realize its net book value of these
assets upon sale or disposition. Additionally, there are inherent problems
associated with selling a substantial division which may adversely affect the
continuing operations of the remaining Security division.
Acquisitions. Cisco, Lucent, Nortel and other competitors have recently
acquired several security companies with complementary technologies, and the
Company anticipates that such acquisitions will continue in the future. These
acquisitions may permit such competitors to accelerate the development and
commercialization of broader product lines and more comprehensive solutions
than the Company currently offers. In the past, the Company has relied upon a
combination of internal product development and partnerships with other
networking and security vendors to provide competitive solutions to customers.
Certain of the recent and future acquisitions by the Company's competitors may
have the effect of limiting the Company's access to commercially significant
technologies. Further, the business combinations and acquisitions in the
security industry are creating companies with larger market shares, customer
bases, sales forces, product offerings and technology and marketing expertise.
There can be no assurance that the Company will be able to compete
successfully in such an environment.
In September 1998, the Company completed an acquisition of certain assets of
the Computer Misuse and Detection System ("CMDS") Division from Science
Applications International Corporation ("SAIC"), a privately held company in
San Diego, California. On September 30, 1999, the Company entered a technology
licensing agreement with RSA Security, Inc. ("RSA") under which the Company is
the exclusive licensee of RSA's Kane Security products in North America and
Europe. The Company may, in the future, acquire or invest in additional
companies, business units, product lines, or technologies to accelerate the
development of products and sales channels complementary to the Company's
existing products and sales channels. Acquisitions involve numerous risks,
including: difficulties in assimilation of operations, technologies, and
products of the acquired companies; risks of entering markets in which the
Company has no or limited direct prior experience and where competitors in
such markets have stronger market positions; the potential loss of key
employees of the acquired company; and the diversion of management's attention
from normal daily operation of the Company's business. There can be no
assurance that any potential acquisition or investment will be consummated or
that such acquisition or investment will be realized.
17
<PAGE>
Product Transitions. Once current security products have been in the market
place for a period of time and begin to be replaced by higher performance
products (whether of the Company's or a competitor's design), the Company
expects the net sales of the older products to decrease. In order to achieve
revenue growth in the future, the Company will be required to design, develop
and successfully commercialize higher performance products in a timely manner.
There can be no assurance that the Company will be able to introduce new
products and gain market acceptance quickly enough to avoid adverse revenue
transition patterns during current or future product transitions. Nor can
there be any assurance that the Company will be able to respond effectively to
technological changes or new product announcements by competitors, which could
render portions of the Company's inventory obsolete.
Manufacturing and Suppliers. All of the materials used in the Company's
products are purchased under contracts or purchase orders with third parties.
While the Company believes that many of the materials used in the production
of its products are generally readily available from a variety of sources,
certain components such as microprocessors and ASICs (application specific
integrate circuits) are available from one or a limited number of suppliers.
The lead times for delivery of components vary significantly and exceed twelve
weeks for certain components. If the Company should fail to forecast its
requirements accurately for components, it may experience excess inventory or
shortages of certain components which could have an adverse effect on the
Company's business and operating results. Further, any interruption in the
supply of any of these components, or the inability of the Company to procure
these components from alternative sources at acceptable prices within a
reasonable time, could have an adverse effect on the Company's business and
operating results.
The Company's operational strategy relies on outsourcing of product assembly
and certain other operations. There can be no assurance that the Company will
effectively manage its third-party contractors or that these contractors will
meet the Company's future requirements for timely delivery of products of
sufficient quality and quantity. Further, the Company intends to introduce a
number of new products and product enhancements in 2000 which will require
that the Company rapidly achieve volume production of those new products by
coordinating its efforts with those of its suppliers and contractors. The
inability of the third-party contractors to provide the Company with adequate
supplies of high-quality products could cause a delay in the Company's ability
to fulfill orders and could have an adverse effect on the Company's business,
operating results and financial condition.
Intellectual Property and Licenses. There are many patents held by companies
which relate to the design and manufacture of data security and networking
systems. Potential claims of infringement could be asserted by the holders of
those patents. The Company could incur substantial costs in defending itself
and its customers against any such claim regardless of the merits of such
claims. In the event of a successful claim of infringement, the Company may be
required to obtain one or more licenses from third parties. There can be no
assurance that the Company could obtain the necessary licenses on reasonable
terms.
18
<PAGE>
Third-Party Products. The Company believes that it is beneficial to work with
third parties with complementary technologies to broaden the appeal of the
Company's network security products. These alliances allow the Company to
provide integrated solutions to its customers, combining ODS developed
technology with third-party products. As the Company also competes with these
technology partners in certain segments of the market, there can be no
assurance that the Company will have access to all of the third-party products
which may be desirable or necessary in order to offer fully integrated
solutions to ODS customers.
Dependence on Key Customers. A relatively small number of customers have
accounted for a significant portion of the Company's revenue. U.S. government
agencies and large system integrators are expected to continue to account for
a substantial portion of the Company's net revenue. The Company continuously
faces competition from Cisco, Cabletron, Lucent, Nortel, Alcatel, 3Com, Axent,
ISS and others for U.S. government networking and security projects and
corporate networking and security installations. Any reduction or delay in
sales of the Company's products to these customers could have a material
adverse effect on the Company's operating results.
International Operations. The Company's international operations may be
affected by changes in demand resulting from fluctuations in currency exchange
rates and local purchasing practices, including seasonal fluctuations in
demand, as well as by risks such as increases in duty rates, difficulties in
distribution, regulatory approvals and other constraints upon international
trade. The Company's sales to foreign customers are subject to export
regulations. In particular, certain sales of the Company's security products
require clearance and export licenses from the U.S. Department of Commerce
under these regulations. Any inability to obtain such clearances or any
required foreign regulatory approvals on a timely basis could have a material
adverse effect on the Company's operating results.
Impact of Government Customers. A significant portion of the Company's revenue
is derived from sales to the U.S. government, either directly by the Company
or through system integrators and other resellers. Sales to the government
present risks in addition to those involved in sales to commercial customers,
including potential disruptions due to appropriation and spending patterns and
the government's reservation of the right to cancel contracts and purchase
orders for its convenience.
General. Sales of the Company's products fluctuate, from time to time, based
on numerous factors, including customers' capital spending levels and general
economic conditions. While certain industry analysts believe that there is a
significant market for security products, there can be no assurance as to the
rate or extent of the growth of such market or the potential adoption of
alternative technologies. Future declines in security product sales as a
result of general economic conditions, adoption of alternative technologies or
any other reason could have a material adverse effect on the Company's
business, operating results and financial condition.
19
<PAGE>
Due to the factors noted above and in "Management's Discussion and Analysis of
Financial Condition and Results of Operations", the Company's future earnings
and common stock price may be subject to significant volatility, particularly
on a quarterly basis. Past financial performance should not be considered a
reliable indicator of future performance and investors should not use
historical trends to anticipate results or trends in future periods. Any
shortfall in revenue and earnings from the levels anticipated by securities
analysts could have an immediate and significant effect on the trading price
of the Company's common stock in any given period. Also, the Company
participates in a highly dynamic industry which often results in volatility of
the Company's common stock price.
Impact of Year 2000
In prior years, the Company discussed the nature and progress of its plans to
become Year 2000 ready. In late 1999, the Company completed its remediation
and testing of systems. As a result of those planning and implementation
efforts, the Company experienced no significant disruptions in mission
critical information technology and non-information technology systems and
believes those systems successfully responded to the Year 2000 date change.
The costs associated with the Company's Year 2000 project were expensed as
incurred, were not significant and were funded through operating cash flows
and working capital. The Company is not aware of any material problems
resulting from Year 2000 issues, either with its products, its internal
systems, or the products and services of third parties. The Company will
continue to monitor its mission critical computer applications and those of
its suppliers and vendors throughout 2000 to ensure that any latent Year 2000
matters that may arise are addressed promptly.
20
<PAGE>
Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Foreign Exchange. The Company's revenue originating outside the U.S. in the
quarters ended March 31, 2000, 1999 and 1998 were 12.6%, 16.2% and 19.4% of
total revenues, respectively. International sales are made mostly from the
Company's foreign sales subsidiaries in the local countries and are typically
denominated in U.S. dollars. These subsidiaries incur most of their expenses
in the local currency.
The Company's international business is subject to risks typical of an
international business, including, but not limited to: differing economic
conditions, changes in political climate, differing tax structures, other
regulations and restrictions and foreign exchange rate volatility.
Accordingly, the Company's future results could be materially adversely
affected by changes in these or other factors. The effect of foreign exchange
rate fluctuations on the Company in 2000, 1999 and 1998 was not material.
Interest Rates. The Company invests its cash in a variety of financial
instruments, including bank time deposits, fixed rate obligations of
corporations, municipalities, and state and national governmental entities and
agencies. These investments are denominated in U.S. dollars. Cash balances in
foreign currencies overseas are operating balances and are invested in
short-term time deposits of the local operating bank.
Investments in fixed rate interest earning instruments carry a degree of
interest rate risk. Fixed rate securities may have their fair market value
adversely affected due to a rise in interest rates. Due in part to these
factors, the Company's future investment income may fall short of expectations
due to changes in interest rates or the Company may suffer losses of principal
if forced to sell securities which have seen a decline in market value due to
changes in interest rates. The Company's investment securities are held for
purposes other than trading. Several investment securities have a maturity in
excess of one year. The weighted-average interest rate on investment
securities at March 31, 2000 was 6.0%. The fair value of investments held at
March 31, 2000 approximate amortized cost.
21
<PAGE>
PART II - OTHER INFORMATION
Item 2. CHANGES IN SECURITIES.
On March 23, 2000, the Company issued 750,000 shares of its common
stock in connection with the exercise of a warrant, by SAIC Venture
Capital Corporation ("SAIC VCC"), at an exercise price of $8.00 per
share. The warrant was originally issued to SAIC VCC's parent
corporation, Science Applications International Corporation, on
September 25, 1998. The shares of common stock issued to SAIC VCC
were issued pursuant to a Section 4(2) exemption from the
registration requirements of Section 5 of the Securities Act.
During the quarter ended March 31, 2000, the Company issued
approximately 128,517 shares of common stock to employees pursuant
to exercises of stock options (with exercise prices ranging from
$1.88 per share to $23.25 per share) under the Company's stock
option plans. In addition, the Company issued approximately 11,492
shares of common stock at $4.89 per share to employees pursuant to
purchases under the Company's employee stock purchase plans. These
issuances were deemed exempt from registration under Section 5 of
the Securities Act in reliance on Rule 701 thereunder.
With respect to the common stock issued pursuant to the warrants,
the recipient of securities represented to us their intention to
acquire the securities issued to them for investment only and not
with a view to, or for, sale in connection with any distribution
thereof. In such case, appropriate restrictive transfer legends
were affixed to share certificates issued.
Item 6. EXHIBITS AND REPORTS ON FORM 8-K.
(A.) EXHIBITS. The following exhibits are included herein:
(27) Financial Data Schedule
(B.) FORM 8-K.
(i) On March 17, 2000 the Company filed a
Current Report on Form 8-K (Item 2) in order
to report the sell of the Company's investment
of 770,745 shares of the common stock of
Alteon WebSystems, Inc. ("Alteon") (Nasdaq:
ATON) for $87.00 per share generating cash of
approximately $67.1 million. The stock was
purchased by HBK Master Fund L.P., an
unrelated party of the Company
(ii) On March 31, 2000 the Company filed a
Current Report on Form 8-K (Item 5) in order
to report the exercise of 750,000 warrants of
the Company's common stock by SAIC Venture
Capital Corporation ("SAIC VCC") for $8.00 per
share generating cash of $6 million. The
warrant was issued to SAIC VCC's parent,
Science Applications International Corporation
("SAIC"), on September 25, 1998 in conjunction
with the acquisition by the Company of the
Computer Misuse Detection System and certain
other intellectual property from SAIC.
22
<PAGE>
S I G N A T U R E S
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized.
ODS NETWORKS, INC.
Date: May 12, 2000 /s/ Jay R. Widdig
-----------------
Jay R. Widdig
Vice President, Chief Financial Officer,
Treasurer & Secretary
(Principal Financial & Accounting Officer)
23
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